Educational Articles

From the Survey: II-VI Incorporated

Geoffrey C. Bell
| November 05, 2011

II-VI Incorporated (IIVI) (pronounced “two-six”) is a developer, refiner, manufacturer, and marketer of high-technology materials and derivative precision components and products. It makes lenses, mirrors, prisms, and other optical components and materials for users in industrial, military, telecommunications, photovoltaic, medical, and aerospace applications. Its products are designed to reduce the cost and improve the reliability of a broad range of products.

In 1971, seven years after receiving his Ph.D in electrical engineering, Carl Johnson, a former Bell Labs (now part of Alcatel-Lucent (ALU)) scientist, founded II-VI Incorporated to produce infrared optical materials for the emerging laser market. After leading the company for more than 35 years, Dr. Johnson gave up his post as CEO in 2007, passing the baton to Francis Kramer, who had been president since 1985. It was after the optical materials cadmium zinc telluride, zinc selenide, and zinc sulfide that Dr. Johnson named his company: cadmium and zinc are found in column two of the periodic table, while tellurium and selenium are part of column six. These elements formed the basis for many of the components manufactured by the company.

By the 1980s, II-VI had become the leading maker of optical components for carbon dioxide lasers. Further, thanks in part to II-VI’s research, the power output of some types of lasers improved from 300 watts in 1971 to 5,000 watts in 1987, the year the company’s shares were first offered to the public. Today, II-VI stock trades on the NASDAQ, and the company’s headquarters are located in Saxonburg, Pennsylvania. II-VI has 6,195 employees, and its biggest competitors include Northrop Grumman (NOC), Saint-Gobain (SGO), and Sumitomo Electric (SMTOY).

The company produces a diverse range of laser-related products for a variety of industries and markets. To remain a leading technological innovator, it pursues a balanced approach to research and development, targeting an overall internally and externally funded budget of between 5% and 7% of annual revenue. The company’s products include optical materials and components for carbon dioxide lasers, and devices to accurately target them to work surfaces; systems related to laser cutting, drilling and welding, and semiconductor and other processing applications; ultra-violet systems used to detect shoulder-launched missiles to help improve low-flying aircraft survivability; and components and products used in optical communications networks, and military infrared optical tools for use in targeting and navigation systems. The company also produces and sells selenium and tellurium metals and chemicals, used as additive materials for metallurgical, glass, and animal feed applications, as well as photovoltaic, infrared optics, thermoelectric coolers, electronic and other industrial applications.

II-VI’s operations are divided into four reportable segments: Infrared Optics, including the company’s infrared optics and materials products businesses, as well as HIGHYAG Lasertechnologie GmbH (36% of fiscal 2011 revenue); Near-Infrared Optics, consisting of the company’s VLOC incorporated subsidiary, the China and Vietnam near-infrared operations, and Photop Technologies (32% of fiscal 2011 revenue); Military and Materials, which includes the company’s Exotic Electro-Optics, Inc. subsidiary, the Pacific Rare Specialty Metals & Chemicals, Inc. subsidiary, and the Max Levy Autograph, Inc subsidiary (16.5% of fiscal 2011 revenue); and the Compound Semiconductor Group, comprised of the company’s Marlow Industries, Inc. subsidiary, the Wide bandgap Materials Group, and the Worldwide Materials group (15.5% of 2011 revenue).

II-VI pursues a vertically integrated strategy, exercising direct control over some of its raw materials inputs, its manufacturing operations, and much of its sales and marketing activities. This allows it to leverage the capabilities of its various businesses to help create additional opportunities across multiple disciplines and markets.

Each subsidiary is responsible for its own marketing and sales functions, conducted through direct sales teams and through representatives and distributors around the world. The respective sales forces develop relationships with original equipment manufacturers (OEMs) and end-users, marketing products through targeted mailings, telemarketing, select advertising, trade shows, and customer partnerships. Customers have included Caterpillar (CAT – Free Caterpillar Stock Report), Volkswagen, and Raytheon (RTN), as well as the U.S. government. In addition to the sales offices the company has at most of its manufacturing sites, it also has sales and marketing subsidiaries in Japan, Germany, China, Switzerland, Belgium, The United Kingdom, and Italy. In all, the company employs 225 individuals in sales and marketing capacities.

The company’s 2007 acquisition of Pacific Rare Specialty Metals & Chemicals added a long-term supply of selenium and tellurium to the company’s operations. For much of its other raw materials needs, II-VI enters into purchase agreements with suppliers, many of whom offer it favorable rates for volume purchases. Major raw materials used include zinc, selenium, zinc selenide, zinc sulfide, hydrogen selenide, hydrogen sulfide, tellurium, yttrium oxide, aluminum oxide, iridium, platinum, bismuth, silicon, thorium fluoride, antimony, carbon, gallium arsenide, copper, germanium, molybdenum, quartz, and optical glass. More than two external supply sources exist for most of II-VI’s inputs, and the company has not faced any supply shortages. Domestic production operations are located in Pennsylvania, Florida, California, New Jersey, Texas, and Mississippi, while its overseas production facilities are based in Singapore, China, Vietnam, The Philippines, and Germany. The majority of the company’s capital expenditures are funneled toward manufacturing operations, and its work process, known as “Make It The Same,” ensures that there are no variations in component quality among the main manufacturing centers.

Throughout its history, the company has used acquisitions to build business around its core strengths in engineered materials and components. In 2001, for example, II-VI completed its purchase of rival Laser Power, after having acquired a 15% stake two years earlier. In 2004, it bought Dallas-based Marlow Industries for about $31 million in cash, which was later integrated into the company’s Compound Semiconductor Group. Most recently, Aegis Lightwave Inc., a supplier of tunable optical devices for high-speed optical networks, was acquired in July for approximately $52 million in cash. Aegis will operate as part of the Near-Infrared Optics segment, and will likely be accretive to earnings in fiscal 2012. Additionally, II-VI pursues joint ventures as another vehicle for growth. In 2009, the company entered into a joint venture with Beijing Supower Science and Technology Developing Co., in which it holds a minority stake, making diamond and laser cutting machines. The company has proven adept at using acquisitions and partnerships to foster growth and is likely to continue both activities for the foreseeable future.

Military business within the Infrared Optics, Near-Infrared Optics, and the Military & Materials segments has been growing, and in fiscal 2011 reached 23% of total sales. The rise in government contracts, and customers buying for government contracts, could leave II-VI increasingly vulnerability to cuts in government spending. Record U.S. deficits and debt levels drape future outlays in uncertainty, and raise the likelihood of project delays or cancellations. Because decreased military spending in the 1990s presented the company with a similar challenge, we think it will be able to weather any government austerity in the future. To compensate for the reduced defense budgets after the end of the Cold War, II-VI reinvested in its businesses, and made acquisitions to enhance its presence in other areas. As noted, the company continues to make buys where synergies can be realized, to widen the product portfolio, and to improve its market presence.

II-VI is likely to find additional growth opportunities in overseas markets, as well. In fact, 59% of the company’s revenue in fiscal 2011 was generated outside the United States, up from 49% a year ago and 44% in fiscal 2009. Further, its reach in high-growth emerging markets has been strengthened, with the Beijing Supower joint venture and the Photop acquisition significantly bolstering II-VI’s position in China, for example. We think prudent strategies, encompassing expansion through internal operations, acquisitions, and international markets, should help II-VI keep up its impressive growth rates, and take up any slack from projected lower defense spending.

At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.